Interest rates are one of those curious economic phenomena that is often talked about but that many don’t always understand. Cuts in interest rates are often lauded and praised, but why? The picture in reality is far more complex. Different parties benefit from changes (up or down) to the interest rates. Broadly speaking:

In March 2020, the Federal Reserve cut its target interest rate to near zero. Today’s article will explore the impacts of these interest rate cuts on the automotive industry.

Among the most sensitive industries out there to interest rate changes is the automotive industry. The source of this sensitivity lies in the large amount of debt that seems to be ever present within automotive companies. A higher interest rate means it’s more expensive for companies to cover their debts, and it squeezes their profit margins tight.

 In June 2020, The Wall Street Journal published an article headlined “The Car Industry’s $1.1 Trillion Debt Problem” in which they discussed the acute pressure applied to the industry in the wake of the COVID-19 pandemic. With balance sheets already under pressure, the moratorium on sales and widespread lockdown policies were truly devastating to their business.

That number of $1.1 trillion may seem unfathomable, but to those in the know it is less surprising. It represents a total debt level of 3.4 times earnings before interest, taxes, depreciation and amortization, according to the newspaper piece. Numbers on Statista show that Ford is the biggest single debt carrier in 2020, with a long-term debt-to-equity ratio of 389.27. General Motors follows them with 203.02.

The primary cause of the cut was to mitigate the potential effects of COVID-19 on the wider economy. An ultra-low interest rate encourages spending and borrowing, which keeps money circulating and flowing through the economy as much as possible. The idea was to prevent the kind of financial and economic disaster that occurred during the global financial crisis back in 2008.

First of all, it should be noted that while auto loans are certainly impacted by the federal rate, their rates won’t necessarily come down as dramatically as those of the Fed’s. According to a piece on bankrate.com, the average rate on a five-year new car loan as of October 28, 2020 was at 4.22 percent. That number was down from 4.6 percent at the start of 2020. It’s not the most dramatic decrease, but it doesn’t translate into monthly and total savings on auto loans. The degree will vary from company to company.

While the numbers on bankrate.com do show an average decrease, the move from the Fed hasn’t translated into significantly lower interest rates for most car buyers. Experts at Cox Automotive pointed to the undeniably negative reaction of the stock market to the cut. They go further to explain that “vehicle demand could actually be hurt by declining wealth and lower consumer sentiment, which typically follows stock market correction.”

TrueCar also crunched the numbers on potential auto loan savings. They claimed that a cut by the Fed of half a percentage point could translate to roughly five to eight dollars a month reduction in car payments. It’s hardly earth-shattering. In the typical term of an auto loan, that would equate to between $400 and $600 in total savings.

With the Fed cut coming at the end of quarter 1, the auto industry would certainly hoped to have seen some improvement by quarter 4 — and many did. While the overall picture was still down for the year 2020, the results of quarter 4 show that the industry managed to finish a disastrous year on a stronger note.

Let’s take GM as an example. According to figures reported on CNBC in January 2021, US sales for GM declined by 11.8 percent in total for 2020, but quarter 4 showed a rise of 4.8 percent compared to 2019. This is a good sign that lower monthly payments has at least helped to tempt buyers back to the local car dealerships.

Americans have also received stimulus checks totaling several thousand extra dollars each in 2020. The final number depended on whether you were single/married and/or had children. Was any of that money used to stimulate the auto industry? Figures from the Peter G. Peterson Foundation say not likely. Even households with income $200,000 and above showed 56 percent using the money for ongoing financial expenses. That percentage was as high as 86 percent for low-income households.

If you’re leasing a car or planning to lease a car, it’s critical that you first understand how your monthly payment is calculated. According to Edmunds, this can be done in 12 steps:

1. Take the MSRP (sticker price) of the car

2. Multiply it by the residual percentage (you can get this number from the dealer)

3. You now have the “residual value.”

4. Take the final offer price for the vehicle as per your negotiation

5. Add in any fees

6. Subtract your down payment and any existing rebates

7. You now have your “adjusted capitalized cost”

8. Subtract residual value from adjusted capitalized cost to get depreciation amount

9. Divide depreciation by the number of months in your lease to get the base payment

10. Add adjusted capitalized cost and residual value to the base payment, and multiply by the “money factor”

11. Add rental charge to base payment to get pretax lease payment

12. Multiply tax rate by pretax lease payment to get final total.

Edmunds give some further examples to show how this translates. On a $30,000 car, it works out to about $407 a month. On a $45,000 car, it works out to $610, but ultimately it also depends on brand, model, trim level, geographical location and your current credit score.

Lease rates are impacted by federal interest rates, just as auto loans are. A higher interest rate would make it more expensive, and therefore a lower interest rate would make leasing more affordable. In fact, experts at Edmunds even recommend leasing for those with good credit scores. They point out that even though potential hikes in interest rates in the future can make leasing seem more expensive, the total amount you spend is still much less compared to buying a new car outright.

If the world of auto leasing is thus impacted, then so too must the world of auto financing.

Since auto loans are sold on a private basis, they are not directly linked to federal interest rates. As we mentioned above, movement within the auto loan rates is inevitably less than the federal rate because the car company is trying to make a profit. The same is true when interest rates rise. USA Today published data in 2017 that showed an increase in rates of 0.25 percent generated only an increase between 0.118 and 0.125 percent depending on the term of the loan.

The fact is that a cut in the federal interest rate (or even an increase) will never impact auto loan rates as much as, say, your personal credit score. Data published on Experian.com, demonstrates a very significant difference in rates for both new and used cars depending on your credit score.

The federal interest rate has nowhere near the impact demonstrated in the table above, meaning that any cut is unlikely to improve the situation for those seeking a better deal on an auto loan. It will always have some impact, but credit score is still king.

But what about for refinancing a car? Banks often recommend that at times when your interest rate improves, you should apply to refinance your auto loan and ease the burden of monthly payments. This happens if and when your personal credit score goes up and you qualify for better rates of interest, but only after you initially signed and began a current agreement. So, should changes in the federal rate also impact your decision on refinancing?

The answer to this depends on the amount of cuts that have taken place since your finance plan began. If the percentage change is lower than 1 percent, then it’s probably not worth making the change. If, on the other hand, the change within your loan period so far has amounted to 2.5 or 3 percent, then it starts to become worthwhile. The key is to understand how federal rates are impacting private auto loan rates. A larger federal cut inevitably increases the reduction it can have on the private loan.

Another critical factor in the relationship of federal interest rates, bank interest rates and those from car makers is the fantastic deals that the latter offers compared to the other two. We looked at some data from findthebestcarprice.com, and it seems that even at the time of writing in January 2021, many manufacturers are still offering 0-percent financing deals on their cars, trucks, SUVs and even luxury vehicles.

In their list, they show the best overall deals, including the following:

These three deals also include bonus cash for buyers ranging from $1,000 to $3,500. Banks can’t compete with these kinds of phenomenal rates. That saves you thousands across a typical loan term of up to 5 years.

Caranddriver.com made a prediction back at the end of November 2020 that a lack of further stimulus checks could mean that car repossessions increase in the coming months. Even with a vaccine rolling out, times remain tough and businesses and individuals have made losses.

The Fed’s December Summary of Economic Projections didn’t contain a single FOMC participant that expected any hike in interest rates through 2021. Five participants expect that there will be a hike sometime by the end of 2022, however, so by then the rates should start to rise. Will that be enough time for car companies to prepare and adjust?

In the meantime, right now remains one of the best times to buy a new car. With low interest rates, and continuing zero-percent APR deals, plus the fact that dealerships are frankly desperate to shift cars and boost sales, it’s a true buyer’s market. A tool like carbevy.com also helps even the odds by allowing you to put in your own payment offering, and seeing which dealers bite. In the current climate, you’re more likely than ever to get positive responses! CarBevy receives your offer then contacts its trusted new car dealerships to take care of everything else. Visit the CarBevy homepage to learn more.